Markets puzzle how to price Le Pen presidency

Heavy inflows into European equity in the week ahead of this weekend’s French election suggest asset allocators have yet to take fright at a campaign which remains wide open.

The fourth straight week of net portfolio purchases, with $600 million committed in the immediate lead-up to the poll, suggest there is a lot of potential room to trade lower should one of the wildcard candidates sneak through into the second-round run-off.

That may raise alarm bells with the French election tighter than ever with just two days until the first round vote. Sovereign pricing has more closely reflected potential dangers, with the spread between French and German issues widening and increasingly volatile this year.

Liberal Emanuel Macron and the Front National’s Marine Le Pen (pictured) are neck to neck at around 22% in most polls; scandal-hit conservative François Fillon is not yet counted out at only four points behind the frontrunners while far-left Jean-Luc Mélenchon has launched a late surge in recent weeks.

Le Pen is campaigning on a pledge of ditching the euro, a redenomination of government bonds, an independent monetary policy and a possible exit from the EU. Both she and Mélenchon have pledged to tear up free trade agreements and greatly increase the national deficit.

But this election does not resemble the binary nature of the Brexit and Trump votes. It is largely expected that even if victorious, Le Pen will not manage take control of France’s National Assembly in the legislative election of mid-June.

Lacking parliamentary majority, she will need to form pacts with rival parties to pass legislation, which will present obstacles to rigid implementation of her protectionist agenda. Other constitutional and legal factors could delay or even block her promise to deliver a Frexit referendum.

The legislative constraints may explain why equity markets have remained fairly sanguine so far, said Lombard Odier chief investment strategist Salman Ahmed. The VSTOXX Index of implied volatility in European equities has remained subdued.

'Markets seem uncertain how to respond to the possibility of a Le Pen presidency,' he noted. 'At the height of the Eurozone crisis in 2011-12, market pricing was notably globalised. With regard to the current risks, it has remained fragmented.'

Spread-betting provider City Index points out that although a Le Pen victory is not the baseline scenario, the euro will be hit if she makes it through to the second round.

By how much will depend on the margin of her opponent’s lead. Unfavourable as polling data may be, the mere fact that she remains in the game could affect the single currency, cause French bond yields to rise and the Cac and Eurostoxx index to drop.

Sentiment may still be too optimistic. Most analysis fails to consider the worst case scenario for investors: a second round where pro-Russia Le Pen faces French Hugo Chávez Mélenchon.

Perhaps unsurprisingly, the far-left contender wants to pull France out of NATO, renegotiate all EU treaties, offer a Frexit referendum, nationalisation, capital controls and salary caps. If a showdown between him and liberal Macron is considered enough to cause a sell-off in French stocks, imagine the aftermath if impulsive French voters decide to pit him against Le Pen.

For those who dismiss the above or view president Le Pen as a distant possibility, worries lie elsewhere. If Macron or even Fillon are elected in office, they say, will they have the courage and a strong enough mandate to push through bold structural reforms?

The result is too close to call. Investors will welcome a Macron presidency with a sigh of relief—his ambitious manifesto is market friendly and his election will signify a return to Europe’s status quo and the safety of centrist politics.

But all bets are still on. Some 30% of registered voters say they may not cast a ballot and more than 25% of those that will, say they may change their vote by election day. With the margin of error bringing the four candidates even closer together, the result is just too close to call.

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